Fixed income investments were one of the real investment stories of 2012 with a huge surge of interest that not only continues to keep pace, but seems to be increasing as investors seek attractive income opportunities amongst the prevailing economic pressures. With these pressures set to continue, we take an in depth look under the bonnet of these plans to find out why they are growing so much in popularity and what they offer to investors.

The need to take stock

Meeting income needs is difficult enough at the best of times but the recent economic environment has been particularly challenging, creating an increased demand on the overall returns from our capital.

With low interest rates set to continue, volatile gilt and bond yields, as well as increasing uncertainty as to what the next few years hold in terms of the UK stock market, these really are challenging times. Throw in the possibility of inflationary pressures rearing their ugly head, and the need to take stock of where our capital is invested is very high indeed.

What is a fixed income investment plan?

The fixed income investment, or reverse convertible to give it its technical name, is a fixed term investment where the level of income received is fixed at the outset. This is paid to you regardless of the performance of any specific shares, or of the stock market as a whole. The return of your initial investment is, however, determined by the stock market, which in most cases is based on the performance of the FTSE 100.

Because the income is not reliant on the performance of the stock market, investors have the benefit of knowing at the outset exactly how much income they will receive and when it will be paid. This certainty of a fixed income as a specified time undoubtedly plays a key role in their rising popularity.

Simple to understand

As with the income, the investment term is also fixed and is normally in the region of five to six years, thereby providing a defined period during which your capital is invested. This combination of a pre-determined fixed income and a fixed term creates an investment that is simple to understand, and is easily comparable to other income investments available in the market.

The average yields on FTSE listed companies remain unexciting and therefore it is not surprising that combining a variable income with full exposure of your capital to risk is not an opportunity which inspires investor confidence, particularly with regard to providing them with a healthy and predictable income stream. In comparison, the defined return for a defined level of risk offered by the fixed income investment is an attractive feature for many investors.

Popular in all markets

Since income is paid regardless of the performance of the stock market, these investments are popular in all markets, provided the level of income on offer is sufficiently high in relation to other income options, and when balancing risk v reward.

The natural comparison for the return on offer is the typical yield achieved on FTSE 100 companies (with possible capital growth on top), as well as the returns from fixed rate bonds. With the latter, your capital is not at risk, and so whether or not to use a fixed income investment is mainly dependent on whether you are comfortable with the upside you receive in return for putting your capital at risk. Certainly the low interest rate environment has forced many to look at how their capital is working and to compare more closely both the capital protected and capital at risk options available.

What does ‘capital at risk’ actually mean?

In order to receive fixed returns that are currently far higher than those available from cash, the investor’s capital is put at risk. This means that although your income is fixed, whether you receive a return of your original capital at the end of the investment term is dependent on the performance of the stock market, normally the FTSE 100 Index.

If the value of the Index has not fallen by more than 50% of its level at the start of the plan, your initial investment will be returned in full. One feature to check is whether this 50% barrier is tested throughout the investment term, or only at the end, since the former is more likely to occur than the latter.

To put both methods into context, based on yesterday’s closing value for the FTSE of 6,246.8, the Index would have to fall to 3,123.4 before your capital would be at risk. Since this is a level not seen since 1995, many investors consider this to be a competitive trade off for the level of fixed returns available. Please note that the past performance of the FTSE is not a guide to future performance.

Counterparty risk

Since your investment is used to buy securities issued by the institution offering the plan (normally a bank), one feature that is important for investors to understand is counterparty risk. This is the likelihood that a particular institution will be unable to repay any money owed which could, therefore, potentially have an impact on your returns independent of the performance of the underlying index.

There are a number of credit ratings available provided by leading credit rating agencies such as Standard & Poor’s, Fitch and Moody’s and although these are only one way of assessing the counterparty to each individual plan, they do provide a useful starting point. In addition, a recent development has seen some plans offer the option to spread this risk by using a number of counterparties although the potential fixed returns on offer with these plans will be slightly lower.

Fixed term

Liquidity can be an important part of investing, since none of us know what lies around the corner and we may need to draw on our investments earlier than planned. Unlike investment funds, daily liquidity is not normally available and the secondary market for this type of investment is still developing so this is an important consideration.

Fixed income investments are designed to be held for the full term. However, most investments should be made on the basis of you not requiring the capital for at least 5 years and as such, fixed income plans are in line with any other investment. In the event of requiring the funds a value can always be obtained from the plan provider, and proceeds are normally available quickly.

Charges

With fixed income investments, all of the charges associated with the operation of the plan are taken into account in the headline return so there are no hidden surprises. A typical fund on the other hand will often have an initial charge (up to 5.5%), and recent figures from the Investment Management Association reveal that the total annual charges for an active UK equity income fund is 1.95%, meaning the fund has to outperform the index by this amount each and every year just to stay level.

The fund does have the ability to achieve capital growth in addition to any income, which the fixed income investment does not. However, the costs associated with the ongoing management of funds provide an immediate return hurdle which is evidenced by the large number of funds that fail to outperform the FTSE each year, and especially over a five year period.

Using your ISA allowance

Finally, all of the fixed income investments detailed by us on www.fairinvestment.co.uk are available for individuals to use their annual stocks and shares ISA allowance and will also accept investment ISA transfers. For the current tax year the annual ISA allowance is £11,280. This will be increasing by £240 to £11,520 from 6th April 2013. Please note that this information is based on current law and practice which may change at any time.

Meeting your income needs….?

The above summary highlights the pros and cons of the fixed income investment for those looking for higher fixed returns and who are prepared to put their capital at risk. The combination of a high return that is not linked to the performance of the stock market and the conditional capital protection providing a return of your initial investment unless the FTSE 100 Index falls by more than 50%, is unique among income investments.

With the current pressure on both savers and investors to maximise the returns they receive from their capital, these features combine to offer an attractive balance of risk v reward when compared with other income investments available.

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No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are at all unsure of the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice. Tax treatment depends on your individual circumstances and may change.

© Fair Investment Company Limited